Shadow Banking and Bank Capital Regulation

Abstract

Banks are subject to capital requirements because their privately optimal leverage is higher than the socially optimal one. This is in turn because banks fail to internalize all the costs that their insolvency creates for the non-financial agents using their money-like liabilities to settle transactions. If banks can bypass capital regulation in an opaque shadow-banking system, it may be optimal to relax capital requirements so that liquidity dries up in the shadow-banking system. Tightening capital requirements may spur a surge in shadow-banking activity that leads to an overall larger risk on the money-like liabilities of the formal and shadow banking institutions.